Wednesday, 22 July 2020

How to Respond to a Stock Market Crash

We don’t want them, we don’t look forward to them, but they are certainly a part of investing in the stock market. Yes, I’m talking about dramatic stock market crashes. 

These tend to occur about once every 5 years (slightly more frequently than an average economic cycle). 

There is no official definition for what magnitude of fall is needed before a temporary slump will be labelled a crash. Some crashes can be particularly deep, such as the dot-com bubble bursting in 2000, which led to the Nasdaq falling by over 75%. 

Other crashes can be shallower but prolonged, such as the 2007 financial crisis impacting the FTSE100, which took over 5 years to return to its pre-crash high.

So while the definition may be a little loose, you’re not going to be particularly bothered about semantics and labels when your portfolio is over 20% in the red, so let’s agree that when you’re experiencing a stock market crash - you’ll be very aware you’re in one.

How to respond to a stock market crash - step 1

The first thing to do is to not panic. In the few weeks of heavy and sustained price falls, it is common to expect that this will continue for weeks and to think about selling your equity investments to try and avoid further pain. 

This is not a clever move. 

The act of selling after a period of losses, first of all, guarantees that you are not selling for an optimum price. If an asset was trading for 10% above its latest value just one week ago, then your trade at the lower price is effectively a fire sale. Not a great way to get the most value from your investment portfolio. 

Secondly, you really do not know what the future holds. Yes, a strong depression in prices over the course of a week could signal that a full stock market crash is coming. But if you study the price graphs of any stock market indices, you will find countless examples where a sharp downward trajectory was cut short and the index soon bounced back. 

Imagine the regret you would feel having sold at 10% below recent values, only to see the stock price recover days later. 

This is why financial advisers and investment managers encourage you to not ‘panic’ when the mood of the market suddenly changes. A stock market crash is not as likely as it might feel. 

Here are some more resources you could visit to learn more:

Investing world

Financial Experts 

Investment properties 

The following resources will be more of interest to beginners, as they go into more detail and bring in new concepts at a slightly slower pace. 

Books promoting 

investing diversification 

I also thought it would be useful to share the final three sources which have helped me tremendously in the last few months and years in gaining new financial insights:

Investment strategy 

Investment portfolio books 

Investing books

How to respond to a stock market crash - step 2

The mindset I encourage you to adopt is one of a predator. When others are weak, this presents an opportunity to pounce and take their lunch. 

In the investing context, I’m talking about the concept of ‘buying the dip’. Buying the dip is the phrase given to buying shares after a savage fall in prices. 

Doing so requires courage because the fact those prices are low suggests that other investors are in a full-blown state of panic about the prospects of corporations.

Buying from these investors is a signal that you believe the long term performance of these businesses will eventually return to the mean, and you will harvest profits as the price tracks back to its original position. 

Buying the dip is not a short-term trading strategy - nobody knows if the stock market will generally rebound in a strong way, or whether it will take years of growth to return to health. Rather, it is a way of ensuring that you buy low. In contrast to the first point - if you buy after a crash, then you know you are getting good value for your portfolio. 

If we only ever bought shares during times of nationwide economic catastrophe, we would probably enjoy consistently higher returns than those who buy shares when times are good. 

How to respond to a stock market crash - step 2

Overall, responding to a stock market crash is a mind-game. There’s nothing technical about it. 

The stock market is issuing you a challenge, and you can either fold or go all in. 

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